(Originally posted on October 14 but several readers have asked me to repost.)
What me worry?
On a day when the Dow Jones Industrial Average closes above 10,000 for the first time in a year and when the Standard & Poor’s 500 stock index closes within kissing distance of 1100 at 1092 ?
When the market is rallying and everyone is getting kind of giddy, it’s exactly when you should be worrying. You don’t want to head for the exits just because an index has crossed some arbitrary number. That’s silly. But you would like to know what the chances are that something will go wrong.
How bad it might be if something did go wrong.
And when. Don’t forget the “when.” Deciding to sell because you’re worried that something bad is set to happen in 12 months is a guaranteed way to leave a big chunk of change on the table.
So what are my worries and what timetable are they running on?
- Regional and local banks could blow up on problems with their commercial real estate loans. I wrote about this in a post on October 8 http://jubakpicks.com/2009/10/08/will-bad-commercial-real-estate-loans-set-off-banking-crisis-ii/ ). More than 800 banks in the United States have more than half their total loan portfolios committed to loans to local real-estate developers, builders, and businesses. The Federal Reserve is worried that banks have been extremely slow to write down the value of the approximately $1.7 trillion of these loans that they carry on their books. The potential crisis, the Fed worries, could be as big as the original market meltdown. When:Perhaps as early as next week when regional banks with potentially big exposure such as Sun Trust Banks (STI), Comerica (CMA) and Zions Bancorp (ZION) report earnings. How bad could it be:Not as bad as the Fed fears, I believe. The banks most likely to be hit aren’t the big money center banks that form the core of the financial system. A failure in this tier of the banking system won’t close the whole system down again. I think there’s a good chance that bad news on this issue could send the financial sector into a stall but even then the damage is likely to be limited if the other big money center banks report results as strong as those already out from JPMorgan Chase (JPM).
- Disappointing fourth quarter earnings guidance. What this rally needs to keep going is more third quarter reports like Intel’s (INTC). Intel raised guidance for the fourth quarter saying that revenue would be as much as $1 billion above Wall Street estimates. That announcement is one of the main reasons that the market rallied with such force on October 14. When: It looks like the big increases in guidance are going to have to come from the technology sector. (Banking results are likely to be all over the place. Commodities and materials stocks are likely to turn in good earnings but, if Alcoa (AA) is any guide, they aren’t going to be show much top line revenue growth, which is what Wall Street wants to see from this sector now.) We’ll know if technology stocks are going to deliver the upside for the fourth quarter that this rally needs in relatively short order. Google (GOOG) and IBM (IBM) report on October 15. Texas Instruments (TXN), the chip company that got the ball rolling, will release financials and projections on October 19. Microsoft (MSFT), which will give investors more insight into growth (or lack thereof) in the PC market, reports on October 23.) How bad could it be: I think a lack of improved guidance for the fourth quarter is enough to stall this market rally. In my mind this is the most likely cause of the 5% to 10% correction that so many investors seem to be looking for. (Just for the record, I think any correction is likely to be short. Too many of those folks looking for a correction are saying they’ll jump in on the dip for me to believe in an extended down market.)
- The pace of the economic recovery could prove disappointing. I know everyone is saying that they expect a slow recovery with the unemployment rate staying stubbornly close to 10% well into 2010 and GDP growth at just 2% or so even after the rebound. But I’m not sure how many people actually believe in that scenario. My suspicion, based on nothing more than my observation of human nature, is that a lot of these investors are saying they believe in this scenario so they won’t be dismissed as Polyannas, but in their heart of hearts they believe that we’ll see the end of the recession in the first quarter (or at worst the second) and job growth commencing shortly after that. If growth doesn’t come hop, hop, hopping down the bunny trail by Easter, I think a lot of the investors now professing belief in the no growth until the second half scenario will be severely disappointed. When: The key events will be guidance coming out of first quarter earnings season (so March). I expect that Wall Street will be disappointed if companies don’t start talking about top line revenue growth then. How bad could it be: Certainly this disappointment would be enough to kill the rally and it would probably lead to the kind of 15% correction that you’d expect after a run like we’ve had in 2009. But hope springs eternal and I suspect that Wall Street would quickly regroup by arguing that, hey, good times are just around the corner.
- The Federal Reserve could raise interest rates setting off a disorderly unwinding of the current U.S. dollar carry trade. You remember the Yen carry trade don’t you? Traders would borrow yen (Japanese interest rates were close to 0% and the yen wasn’t appreciating against any major currency) to invest them in things like commodities, stocks, U.S. Treasury bonds. Anything that provided a better return than the interest rate on the yen loan. Pile on enough leverage and you could make a huge profit. Well, we’re seeing the same thing now but with the U.S. dollar. Interest rates on the dollar are close to 0% so it doesn’t cost much to borrow in dollars. The dollar is falling in value against most of the world’s currencies so anybody who borrows in dollars gets to pay back the loan in cheaper dollars. And many of the world’s markets are rallying so it’s not hard to make a profit on your borrowed money. The problem with this situation is that cheap dollars are pouring into financial markets sending the price of oil, gold, Brazilian stocks, and a lot of other things you can name up and up. When the music stops and these dollars get pulled out of these markets, you can expect asset prices to correct. What would cause the end of the dollar carry trade? A Federal Reserve interest rate increase that reversed the fall of the dollar. Borrowers would flock to repay their dollar-denominated loans before a rising dollar made them more expensive. When: Best guess right now is that Federal Reserve won’t raise interest rates before the last half of 2010. How bad could it be: An end to the dollar carry trade would pummel commodity prices and emerging country financial markets. I’d want to be out of these assets when this hit.
- We could wind up with an anemic recovery and then dip into a second recession. Happened in 1937. (For more on what happened in 1937 read my September 22 post http://jubakpicks.com/2009/09/22/we-have-nothing-to-fear-but-a-replay-of-1937-itself/ ) This would kill the rally and send us back into a bear market in all likelihood. When: The second half of 2010 or sometime in 2011 when the stimulus money runs out. How bad could it be: Very bad. I’d want to be on the sidelines for this if I can be. The market would likely retrace a considerable portion (or all) of the gains of the current rally.
I fins this list of worries and their potential schedule very useful as we climb higher and higher and get closer and closer to the end of this rally.
From my list you can see there are worries, #1 and #2, that could set off relatively minor corrections as early as next week. The magnitude of these corrections (which of course are only possible and not guaranteed) isn’t enough to make me jump to the sidelines.
The first moderately serious worry, #3, one big enough to make me think about wanting to miss the damage, is still only a 15% correction and doesn’t arrive until March 2010 or so.
The biggies, #4 and #5, the ones I definitely want to take action to avoid, are probably not a worry until the middle of 2010. I want to keep an eye on these scenarios, since the results are serious enough to make them really, really painful to anyone trying to rebuild a portfolio.
But I don’t need to move to the sidelines to avoid these possibilities just yet.
You shouldn’t take any of these to mean that the market has to keep roaring ahead at its pace of the last six months. Or that you should take on stocks with high price to earnings ratios.
Caution is always a good thing when a rally has taken a stock market up 60% in six months.
But my list says you don’t need to go running to the sidelines right now just because we’re challenging 10,000 on the Dow and 1100 on the S&P.